Thursday, December 18, 2008

More thoughts on fiscal policy: tax cuts

This week, I have expressed my concerns about the ever-growing size of the fiscal stimulus package. I decided to offer up a little chart-style description to illustrate the effects of a stimulus package driven primarily by tax cuts, rather than Obama's $850 billion spending plan.

The charts illustrate Macroeconomic Advisers’ (the all-star forecasting firm – including Laurence Meyer who sat on the Board of Governors) baseline forecast that includes a stimulus package, and an alternate forecast where no stimulus is added. The highlights of the December 8, 2008 forecast are (this is a paid subscription, but I can send it to you if you email me):
  • In the stimulus forecast, the economy starts to expand in 2009.3 (third quarter of 2009), and rebounds quickly throughout 2010. The unemployment rate peaks at 8.5% in 2009.3 and starts to descend in 2010.2.
  • In the no-stimulus forecast, the economy starts to expand in 2009.4 and rebounds more slowly throughout 2010. The unemployment rate peaks at 9.5 in 2010.2 and starts to descend in 2010.4.
The defined stimulus package is $416 billion over the next two years, and $930 billion in five years. The share of each component in the first two years is:
  • Infrastructure spending, 24%
  • Increase in Medicaid matching, 10%
  • Extended unemployment benefits (included in both forecasts), 5%
  • Individual income tax cuts, 61%
Now that Barack Obama pledges to spend $850, this forecast is already outdated, but it does illustrate the effects of a fiscal stimulus driven by tax cuts. From Bloomberg:
The latest proposal is circulating in Congress as Obama’s advisers work with lawmakers to craft a package aimed at improving roads, bridges and other parts of the U.S.’s crumbling infrastructure. The plan probably will also include state aid for unemployment and health-care programs and incentives such as tax credits to promote renewable energy production, lawmakers have said.
Tax credits to promote renewable energy production? That sounds like an sure bet to boost the economy.

Tax cuts really should be a large share of the fiscal stimulus. An increasing share of individuals and firms are cash constrained, and it is more likely that most of the tax reductions will be spent, rather than saved. Imagine $850 billion in tax breaks over the next year (about 6% of GDP)!

From Greg Mankiw:

My advice to Team Obama: Do not be intellectually bound by the textbook Keynesian model. Be prepared to recognize that the world is vastly more complicated than the one we describe in ec 10. In particular, empirical studies that do not impose the restrictions of Keynesian theory suggest that you might get more bang for the buck with tax cuts than spending hikes.
Compared to choice previous recessions (I picked the deepest and/or longest since 1950), this recession will be deep and long.

The chart illustrates previous recessions, as measured by real GDP and dated by the National Bureau of Economic Research (NBER). The current cycle (2007-current) includes the forecast values from Macroeconomic Advisers’ under the stimulus and no-stimulus scenarios. The values for GDP have been indexed to 100 at the start of each recession for comparison, and a 6-quarter recovery period after each recession's end is included.

The 1981-1982 recovery was quick, where with or without fiscal stimulus, the 2007-2009 recession will not be; this is typical of recessions that include a financial crisis. Reagan passed the Economic Recovery Tax Act of 1981 (ERTA), which contributed to the quick recovery following a very deep recession.

Compared to previous recessions, the unemployment rate will rise very quickly.

This chart indexes the unemployment rate to 100 at the onset of the recession for previous cycles and the current cycle (similar to the previous chart). The current cycle is expected to produce a serious labor market contraction with or without the stimulus package, but even more extreme without the fiscal stimulus. Furthermore, the unemployment fell quickly in the wake of Reagan’s ERTA.

I don’t like Obama’s plan. If the government must spend massive amounts of money, why not put it directly into the hands of consumers and firms via tax cuts. It will work quickly, and history suggests that the effects can be quite dramatic.

The quickest way to create some demand is via tax reductions and not spending on infrastructure and roads. The Obama plan is too complicated, too slow, and obviously increasing in magnitude with each week, no day, that passes.

Rebecca Wilder


  1. Great charts! Keep'em coming!
    Poor Obama. He's been put in the "Savior" category by so many and is taking on the mantle (not the 1st person who's done that). It demands that he respond positively to pretty much all who come to him for aid. That would include all the Congress members who want $$ for their states. Ergo, we do infrastructure fixes like the 30's. Did he ever say he was a fan of F. Roosevelt?

  2. Let me ask a simple question. Why fiscal policy at all, i.e. what is the rationale?

    The gov't has no ability to generate revenue on it's own - it's only source of funds is taxation or printing. So the gov't takes money from the people only to turn around and spend it on something of its own choosing, for example, infrastructure. Leaving the moral issue aside, why do we believe this is necessary? Why would a few central planners know better what the economy 'needs' than the individuals in the market?

  3. Btw, the above comment is meant to stimulate discussion. The underlying answer is included in this very blog: "...and it is more likely that most of the tax reductions will be spent, rather than saved."

    Saving IS spending.

  4. Anonymous writes:
    [qt]Saving IS spending.[/qt]
    Errrr....not quite. If there is some trick of semantics contained in your phrase, it's blown right past me.

  5. No, no trick. I mean it. With the minor exception of putting cash under your mattress, any money saved is actually spent. And, more importantly, spent predominantly on productive expenditures rather than consumer expenditures.

    Real wealth is created by a productive labor force. Productivity of labor is increased by growing the capital supply, i.e. by increased productive expenditure, i.e. by savings. How? Wages are paid out of savings. Business expenditures are paid out of savings. This all follows from the Classical Economists recognition that 'Demand for Commodites is not Demand for Labor' (see JS Mill).

    For anyone keeping score in terms of GDP, remember GDP is equal to consumer expenditures plus NET investment. The NET part is the difference between two very large, but similar (in magnitude) numbers, namely productive business expenditures and business costs. A growing GDP doesn't mean a growing capital base or growing real wealth.

    Fiscal stimulus and encouraging consumers to spend may make GDP look good. But in fact it takes money away from productive expenditure and shrinks the supply of capital goods, lowering the productivity of labor. Why would we want that?

    Btw, I'm all for tax cuts. But if you don't decrease gov't spending at the same time, how are tax cuts supposed to help?


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